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Appendix I. Sample of Countries MEXICO Appendix I. Sample of Countries Sample of Countries Latin America Asia Emerging Europe Other Argentina India Belarus Turkey Brazil China, Mainland Kazakhstan South Africa Chile Indonesia Bulgaria Israel Colombia Republic of Korea Russian Federation Mexico Malaysia Ukraine Peru Pakistan Czech Republic Uruguay Philippines Slovak Republic Venezuela, Rep. Bol. Thailand Estonia Latvia Hungary Lithuania Croatia Slovenia Poland Romania INTERNATIONAL MONETARY FUND 17 ©International Monetary Fund. Not for Redistribution MEXICO Appendix II. Regression Results – EM Bond Factor (1) (2) Full Sample Post crisis vix -0.0465*** -0.0635*** (0.0122) (0.0116) wti 0.0106*** 0.00836* (0.00255) (0.00457) L.adv_growth -0.0708* -0.0616 (0.0393) (0.0861) L.bric_growth 0.0712*** 0.339*** (0.0259) (0.0545) fed funds 0.241 -1.985 (0.195) (4.319) _cons -0.113 -1.040** (0.350) (0.391) N5924 R-sq 0.519 0.749 18 INTERNATIONAL MONETARY FUND ©International Monetary Fund. Not for Redistribution MEXICO WELFARE GAINS FROM HEDGING OIL-PRICE RISK1 Since at least 2001, Mexico’s federal government has hedged the near-term fiscal impact of declines in oil prices through put options. Using a structural model calibrated to the Mexican economy, we quantify the overall benefits of this long-standing policy. Compared to a self- insurance alternative, we find welfare gains from hedging through put options equivalent to a permanent increase in consumption of 0.4 percent. These gains arise mostly from a reduction in sovereign spreads and to a lesser extent from smoothing income volatility. In terms of design, expanding the program to cover domestic fuel sales could yield further gains once gasoline and diesel markets are liberalized. Relying more on liquid instruments—such as options on the Brent—is an avenue worth exploring to ensure the program remains cost effective. A. Introduction 1. Mexico’s hedging program has the objective to hedge the value of Mexican oil exports at a strike price that is consistent with the one assumed in the budget for each year. To meet this objective, the program involves buying Asian put options to insure the price of oil for the whole year. 2 The execution involves purchasing options with Maya oil—a type of Mexican heavy crude oil—and Brent as underlying assets, although the former dominates as Maya oil represents about 80 percent of Mexico’s oil export volumes. 2. The program helped cushion the Cash Flow from Options (In percent of GDP) fiscal impact of the decline in oil prices in 0.7 2009, 2015, and it is expected to do so 0.6 Inflows again this year. Since 2001, the options had Outflows 0.5 a cost, on average, of 0.1 percent of GDP per year, but were exercised only in 2009 and 0.4 2015, yielding payoffs close to 0.6 percent of 0.3 GDP in each occasion. It is expected that the 0.2 options will be exercised again this year, 0.1 yielding estimated revenues for 0.3 percent - of GDP. 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Source: National authorities; and IMF staff calculations. 1 Prepared by Chang Ma and Fabian Valencia. The authors thank Dora Iakova, Alexander Klemm, Damien Puy, Robert Rennhack, Alejandro Werner, seminar participants at the IMF and the Bank of Mexico for comments and suggestions. 2 An American or European put option is exercised if the spot price on a particular day exceeds the strike price. In contrast, an Asian put option is exercised if the average spot price for a pre-determined period, which in the case of Mexico is one year, exceeds the strike price. In this way, Mexico guarantees a minimum average price of oil for the whole fiscal year. INTERNATIONAL MONETARY FUND 19 ©International Monetary Fund. Not for Redistribution MEXICO 3. This paper examines the welfare gains for Mexico from having the hedging program. Using a structural model, this paper asks three questions: 1) how large are the welfare gains from using put options to hedge oil price risk; 2) what are the main channels through which these gains operate; and 3) what design considerations can increase the benefits of the program further. B. Model Setup 4. The model summarizes a small open economy with representative consumers who receive income from oil and non-oil sources and consume a tradable good. The model is a standard sovereign default model (Arellano, 2008). It is assumed that a social planner (i.e. the government) makes decisions aimed at maximizing the present discounted value of private agents’ utility derived from consumption ( Ct ): t EUC0 ()t . t0 Income resembles the structure of fiscal revenues, with oil and non-oil sources. The non-oil sources (e.g. taxes, denoted ft ) are assumed to evolve deterministically. Oil revenues stem from exports and from domestic sales.3 A fraction of oil export volume (Q)—assumed fixed—is hedged through put options, which guarantees an oil price at least as good as the strike price p .4 Yfmax{ ppQpQ ,0} dd. (0.1) tt t t fiscal revenue non-oil revenue exports domestic sales Oil Revenue 5. The country purchases put options every year to hedge against a fall in oil prices. The government defaults on its liabilities whenever it is optimal to do so. In other words, the country defaults if Vpfdc(,) VBpf (,,)maxUC( )) EVB ( ,p ,f , ttttttt CBtt,11 t ttt1 t1 t1 d c where Vpfttt(,) and VBpftttt(,,)denote the present discounted value of the utility from consumption if the country defaults or not in period t, respectively. VBptttt1111(,,) f denotes the present discounted value of consumption as of the next period (t+1), If the country does not default, the available resources to consume are what remains after receiving revenues Yt , issuing new debt ( 3 d Domestic sales are net of imports. The price pt represents an average price across fuels. The model is expressed in constant U.S. dollars. 4 In the model, the central government and the state-owned oil producer, Pemex, are seen as one entity. In practice, the oil hedging program is only intended to hedge the exposure of the central government to oil price risk, given that Pemex has its own independent operation. Pemex currently does not hedge its own revenues. (continued) 20 INTERNATIONAL MONETARY FUND ©International Monetary Fund. Not for Redistribution MEXICO Bt1 ) at price qt , repaying existing debt, Bt , and purchasing put options to insure Q barrels of oil at a cost of()pt per barrel: CYBqBttttt 1 Qp() t. (0.2) If the country defaults, it resorts to autarky but it can still hedge oil price risk.5 In addition to being unable to issue debt, default implies an income loss equal to h.6 In case of default, the resource constraint boils down to CQptttYh () t. (0.3) There is, however, a positive probability ( ) that the country exits its default status and issues debt again. This possibility is taken into account in the calculation of the present discounted value of future utility of consumption and hence in the default decision: d d Vpfttt(,) UC()ttttEVp ttt(0,,11 f ) (1) EVp tt (11 , f) 6. The price of sovereign bonds and put options is determined in international financial markets by risk neutral investors. The underlying assumption is that international investors hold diversified portfolios and price bonds and options as to ensure an expected return equal to the international risk-free rate ( r* ). Because the ex-ante rate of return on these instruments is the same, the risk-neutral investor is indifferent between holding a bond or being the counterpart of a put option. EDBpftttt1(,,) 111 qB(,,) p f , with DB(,,)1 p f if country defaults (0.4) tt1 tt 1 r* ttt111 Epp[max{ ,0}] ()p tt1 (0.5) t 1 r* 7. The model is calibrated to the Mexican economy taking some parameters directly from data and the literature, while estimating others to match chosen data moments. The full model and solution are described in Appendix A. We take from the literature the coefficient of risk aversion. We measure directly in the data the real risk-free interest rate (approximated by the yield on 1-year U.S. treasury bonds deflated with the U.S. GDP deflator); the oil-price process (estimated using an AR1 on the price of the Mexican mix); oil export and domestic sales (net of imports) volumes; the fraction of export volumes hedged; and the deterministic growth rate of non-oil 5 The underlying assumption is that debt and financial derivatives are separate markets. 6 Following Arellano (2008), we assume that income is lower than under no default but it can at most drop to some * value y , which will be calibrated to match sovereign spreads in the data. INTERNATIONAL MONETARY FUND 21 ©International Monetary Fund. Not for Redistribution MEXICO * revenues. The discount factor and the parameter y of the loss function under default are chosen as to match the government’s gross financing needs and the average Mexican sovereign spread over U.S. treasury bonds. Tables B1-B3 in the appendix show the complete set of parameter values and simulated data moments. C. Welfare gains and channels 8. The benefits of hedging are computed relative to a self-insurance alternative. Using Monte Carlo simulations, we construct paths for consumption and contrast them with those from a version of the model without hedging.7 In absence of hedging, consumption-smoothing takes place solely through issuing debt. The welfare gains from hedging can be expressed in terms of the permanent increase in consumption that would yield the same present discounted value as in the model with hedging.
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